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Unformatted text preview: PADP 6950: Founda1ons of Policy Analysis Demand Angela Fer1g, PhD Consumer Choice Demand A useful feature of the consumer choice model is it gives us a rigorous way of understanding where demand curves come from: Demand curves arise from the u1lity-maximizing consump1on choices made by consumers To derive an individual's demand curve for a par1cular good X, look at what happens to the op1mal bundle when the consumer is confronted with a series of changes in the price of good X 1 Deriving Individual Demand Curves Y 1 2 3 4 Price offer curve PX PX1 PX2 PX3 PX4 X1* X2* X3* X4* X 1 2 3 4 demand curve X Ordinary vs. Giffen goods Ordinary good: demand increases when price falls (downward sloping D) Giffen good: demand decreases when price falls (upward sloping D) E.g. Ground beef (in my case) when price falls, I feel richer, I buy steak instead E.g. Jordache jeans when price was high, I thought they were cool, bought more; when price falls, I think they are no longer cool, I stop buying them 2 Deriving Market Demand Curves We know that for each individual consumer, the demand curve for a good arises from the u1lity-maximizing consump1on decision based on preferences, income and prices. The market demand curve refers to the rela1onship between the price of the good and the total quan1ty demanded by all the consumers in the market. We obtain the market demand curve by adding up the quan11es demanded by all consumers in the market at each price Calcula1ng the Market Demand Curve Suppose the market for a certain good consists of two consumers (A and B) with the demand schedules listed in the table below Use this informa1on to obtain the market demand schedule for the good (last column labeled QDM) P 5 4 3 2 1 0 QDA 0 1 2 4 6 7 QDB 0 4 5 6 8 9 QDM 3 Graphing the Market Demand Curve Use the informa1on in the previous table to draw a graph of the individual and market demand curves P 5 4 3 2 1 Q 2 4 6 8 10 12 14 16 dA dB The market demand curve is the "horizontal summa1on" of the individual demand curves Elas1city An important property of the market demand curve is how much quan1ty demanded responds to changes in the market price This helps analysts predict what will happen to consump1on if a policy causes a change in price The analyst needs to do two things: Figure out how much the price will change because of the policy Figure out how much the quan1ty will change because of the change in price (elas1city helps with this part) 4 Price Elas1city of Demand The "price elas1city of demand" is the percent change in quan1ty demanded due to a one percent change in price ( just use absolute values) D = %QD / %P D = (QD/Q) / (P/P) If the price elas1city is greater than 1, then demand is said to be "price elas.c" If the price elas1city is less than 1, then demand is said to be "price inelas.c" If the price elas1city is equal to 1, then demand is said to be "unit elas1c" Inelas1c Demand Suppose that quan1ty demanded is very unresponsive to price changes Then demand is said to be inelas1c P Even though there is a large price change, the quan1ty change is small P Q Q 5 Elas1c Demand Suppose that quan1ty demanded is very responsive to price changes Then demand is said to be elas1c P Even with a small price change, the quan1ty change is large P Q D Q Elas1city vs. Slope Elas1city is related to slope, but preferred by economists because it is unit-free D = (QD/Q) / (P/P) D = (QD/Q) * (P/P) D = (QD/P) * (P/Q) D = (1/slope)*(P/Q) 6 Midpoint Elas1city Formula Use the formula %Q = (Q2 Q1) / ((Q1+Q2)/2) And %P = (P2 P1) / ((P1+P2)/2) P 10 8 A D = 9 B Between A and B: %Q = Use the average not the ini1al point as the denominator 25 / 12.5 = 2 %P = -2 / 9 = -0.222 D = 2 / 0.222 = 9 Between C and D: %Q = C D = 0.111 D Q 25 / 112.5 = 0.222 %P = -2 / 1 = -2 2 25 D = 0.222 / 2 = 0.111 100 125 Elas1city along a linear demand curve D > 1: Demand elas1c D = 1: Demand unit elas1c Demand inelas1c D < 1: 7 Moves Along the Curve vs. Shios If the price of the good changes, we move along the demand curve P1 P2 Q1 Q2 There is a "change in quan1ty demanded" If there is a change in some other factor that affects demand (like the price of another good), the demand curve shios P1 There is a "change in demand" Q1 Q2 Demand Shio Example 1 What happens to the demand curve for hot dogs if the price of steak increases? P Assume the goods are "subs1tutes" D1 Q 8 Demand Shio Example 2 What happens to the demand curve for hot dogs if the price of ketchup increases? P Assume the goods are "complements" D1 Q Demand affected by other factors Some1mes we are interested in how demand responds to other factors Price of other goods Income These are demand "shioers" 9 Other Prices If demand of A rises when price of B rises, then A and B are subs.tutes (coffee & tea) If demand of A rises when price of B falls, then A and B are complements (coffee & sugar) Cross-price elas.city of demand: XY = %QX / %PY If XY > 0, goods X and Y are subs1tutes If XY < 0, goods X and Y are complements Demand and Income Just like there was a price offer curve, there is an income offer curve Y 3 2 1 Income offer curve Income m3 m2 m1 X1* X2* X3* X Engel curve 3 2 1 X 10 Income Elas1city of Demand The "income elas1city of demand" is the percent change in quan1ty demanded due to a one percent change in income I = %Q / %I Normal vs. inferior goods Normal good: demand increases when income increases Inferior good: demand decreases when income increases Income elas.city of demand: If I > 0, the good is normal If I < 0, the good is inferior E.g. Ground beef (in my case) when income rises, I buy steak instead (same example as Giffen good) But can't use Jordache jeans example if price goes up, I buy more (Giffen good), but if income goes up, I buy more (normal good) I = %Q / %I 11 ...
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